Economics is not a complicated science. This may not seem obvious to you if you’ve following the news from Washington, where a cabal of politicians, financiers and lobbyists have been spent the last several weeks desperately making a series of increasingly complicated, expensive, and ultimately unsuccessful plans to “save the economy.” As the costs of their schemes have spiraled from billions and into the trillions of dollars, it has become increasingly urgent for you, the source of Congress’ deep pockets, to examine the potential impact of their actions on your taxes, savings, and investments. Even if you have no intention whatsoever of voting this November (which, given the choices, is hardly unreasonable), it would behoove you to take the consequences of the pending federal bailout into consideration for your own benefit.

The key to understanding economic theory is to grasp that the same principles that apply to your personal finances, and perhaps to your interaction with your local grocer apply equally to the world at large, at all levels of economy activity. The key to understanding politics is to grasp that political success requires advocating policies which violate these basic economic principles – and then evading the consequences of their own policies – with the voters’ eager participation in the delusion.

A Potato Farmer Learns About Business Cycles

Suppose, for example, that you grow heirloom potatoes. Each season, you harvest most of the potatoes for consumption or sale, and save a fraction to plant the next season. The saved potatoes are your supply of loanable funds – the consumption you forgo now to invest in future production. The percentage of saved potatoes is your savings rate, and also your interest rate, since the consumption you forgo now is your investment in next season’s production capacity. Suppose that you have reached an equilibrium, so that each year’s saved potatoes are just enough to produce the same sized crop next year. Common sense indicates that you cannot increase your future consumption of potatoes without an increase in savings, and therefore a decrease in present consumption. This is a key point – increasing the rate of economic growth is only possible through increased investment. Increased investment is only possible through increased saving. An increase in saving requires a decrease in current consumption. The same principle applies when you decide to dine out less often this month to afford a new iPod next month.

Imagine that you keep track of your remaining potato stock in a ledger. If your ledger is accurate, each hash mark in the ledger corresponds to a real potato – the potatoes are your “gold standard.” For a while, potatoes are plentiful and life is good. Then, one day, you see a commercial for the latest product from Apple – the iTater, a laptop made from potato starch. You must have it – but your ledger shows that the expense would cut into next year’s seed stock. No problem – you just add another zero to the count of remaining stock and proceed to the nearest Apple store. You experience utopia with your iTater – welcome to the boom phase of the business cycle! Your constituents (the wife and kids) are happy, consumer spending is up, and interest rates are down (saving potatoes requires less of a sacrifice in current consumption – according to your ledger.) You have taken your ledger off the “potato standard” and created a fiat currency – but who cares, life is good, right?

What happens next season? Since the act of writing down numbers does not actually conjure up potatoes, you will be unpleasantly surprised when your stock of real investment capital suddenly runs out, and is not sufficient to meet planned expenses. You may be forced to liquidate your assets at a large loss (the iTater market is not so hot now that the iTater 2.0 is out), and without a true accounting of available investment capital (the seed stock in your cellar) long term planning becomes impossible. Welcome to the bust phase of the inflationary business cycle!
If you wise up to your economic fallacies, you will cut current consumption (no iTater Lite for the kids) to restore savings rates and pay debts. But suppose that you take a hint from Washington, and decide to implement a “bailout plan” by adding some more zeroes to your ledger, and resuming unsustainable consumption level by getting the tots the iTater Lites. You might even get a loan from your neighbor Mr. Wen.

What happens now? You’ve “rescued” your personal economy this season at the cost of further depleting your investment capital. You’ve won the “vote” of your kids this season, but you have even less capital for next season. Rather than allowing your personal economy to recover, you have further distorted your grasp of reality, and now have no idea how many spuds you have to consume, and how many you need to save. You can attempt borrow seed stock from your neighbor Mr. Wen, but unless you can drastically cut consumption to pay interest, he will eventually grow impatient and refuse to lend any more. The more you attempt to extend the illusion, the farther out of touch you become with reality, as the numbers on your ledger show exponential growth upwards while your actual consumption plummets toward zero. You’ve discovered hyperinflation, the ultimate destiny of all fiat currencies.

The Roots of the Housing Crisis

Let’s now apply the analogy of the potato farmer to the mortgage crisis our economy is now experiencing. The seeds of the crisis were laid during the New Deal, with the federal government’s creation of Fannie May and Freddie Mac for the purpose of allowing mortgages to be issued at below market rates. In other words, they are a form of price control (a price ceiling) on interest rates for home mortgages. As with all price ceilings, the consequence of making goods artificially cheap is a shortage. In this case, the physical supply of building materials, land, architects, and construction workers is not sufficient to meet demand. The existence of coercive government price controls is obscured by a number of elements intended to maintain the myth that every American family has a “right” to a home. The elements include the superficially “private” charters of Freddie and Fannie (and now, the other institutions being bailed out), the extra-legal guarantees provided to those entities (massive lobbying and high-level relationships with both political parties), and the indirect way the costs of shortages are paid (price inflation, rather than an increase in taxation).

Much of the blame for the mortgage lending meltdown has been placed on the “failure of the free market.” But is there really any truth to this? The financial industry is the single most regulated industry in the economy. The failing institutions are precisely the ones that New Deal policies were meant to protect us from: the FDIC was supposed to prevent bank runs, the SEC was supposed to be stop shady investments, Fannie May and Freddie Mac were supposed to make sure that loans went to people who deserved them. Opportunistic politicians like John McCain are quick to blame the capture of regulatory institutions on lobbyists and “special interests.” He promises to fix the problem by giving yet more money and power to corrupt government agencies, much like a mob boss who blames his enforcers for his protection schemes, and then promises his victims to lay off them if they just give him more guns and money. The only reason that special interests are so involved in government is that the government has ingrained itself so deeply in our lives. Giving more power to the state to regulate markets and redistribute wealth and privileges from one group to another only increases the incentive to strengthen one’s political connections.

There are two particular stimuli for the present housing “crisis.” First, is the expansion in the money supply by the Federal Reserve, motivated in part by the desire to pay for American overseas commitments without a proportionate increase in taxes, in part as a response to the destructive consequences of the anti-business sentiment that created regulations like Sarbanes-Oxley, and as a response to its own inflationary policy of the late 1990’s, which (much like the case of the unfortunate farmer) resulted in the boom and bust of the Dot Coms. Second, is the 1995 Community Reinvestment Act, which basically forced banks to make unprofitable subprime loans to poor neighborhoods and minorities. In 1999, the repeal of the Glass-Steagall act was tied to the CRA rating of banking institutions, again forcing them to make unprofitable mortgages. As the consequences of the loose money policies and the CRA began to come crashing down in 2008, the government responded with HOPE NOW and Project Lifeline, which use a combination of threats and taxpayer-sponsored bribes to prevent the markets from self-correcting. Unfortunately, as our farmer learned, attempting to fix over-consumption by increasing consumption only makes the situation worse.

The vicious pattern of inflationary business cycles is a downward spiral that is not a creation of the unrestrained greed of businessmen. Yes, businesses are complicit to the extent that they have taken part in the state’s redistribution of funds from taxpayers and dollar users. But this is only a minority of politically-connected enterprises. The Community Reinvestment Act is in fact an attempt to force financial institutions to become altruists – that is, act against their own self-interests. The mortgage crisis is primarily the inevitable result of a political-economic ideology that essentially attempts to turn wishes into reality through collective delusion. This ideology is in turn the product of a philosophy that rejects objective reality in favor of a reality created by the collective consensus, rather than the inescapable consequences of cause and effect.

The Philosophy of Make-Believe Economics

The German philosopher Emmanuel Kant famously argued that there are two realities: the noumenal, which is the way the world really is, and the phenomenal, which is the way conscious beings perceive it with their senses. Since the conceptual faculty is an object of distortion, the real world is forever beyond human understanding. Our perception of reality is therefore only an illusion, but it is a collective delusion, shared by all of society. American philosopher John Dewey took Kant’s premises to their natural conclusion: since “ultimate” reality is unknowable, social consensus is the sole determinant of truth and morality. Dewey rejected the notion of truth and of right and wrong as such, and held that pragmatic experimentation should be our sole guide to action, with democratic consensus as the ultimate manifestation of truth, morality, and political change.

Few people act like our potato farmer and deny the objects and events that happen before his very eyes. Yet in economic matters, most people, including most politicians, mainstream economists, and investors unconsciously follow Dewey’s philosophical principles: reality is ultimately driven by social consensus, and the success or failure of markets depends only on the optimism or pessimism of consumers and investors. This is more than the belief that wishes and prayers affect reality – this is a belief that one’s wishes are reality – if only enough people share the delusion.

The Federal Reserve and the Treasury Department are faithful followers of Dewey and Kant. By artificially lowering or raising interest rates, the government attempts to turn our perception of reality (the interest rate) into reality – our actual propensity to save. But pretending that there is a sufficient stockpile of spuds in the cellar is not the same thing as having a sufficient stockpile. The artificial manipulation of interest rates leaves investors flush with cash, but short on worthwhile investments (or vice versa) and thus diverts increasingly scarce resources into increasingly inefficient investments. Prudent investors (like the banks not in this week’s news stories) stay away, while politically-connected spendthrifts splurge. Markets become increasingly unstable, and sooner or later, things come crashing down. The more you attempt to evade reality, the worse the disaster that you are asking for will become.